Investing in Stocks: Ignore the Negatives, Embrace Your Contrarian Side and Buy Stocks Now

Investing in Stocks: Ignore the Negatives, Embrace Your Contrarian Side and Buy Stocks Now
by Alexander Green, Investment U’s Chief Investment Strategist
Tuesday, September 7, 2010: Issue #1338

When the Dow bottomed near 6,500 in the thick of last year’s financial crisis, few investors thought it was a good time to buy stocks. Sentiment was overwhelmingly bearish.

So when the market bounced higher, the consensus was that it was a “dead-cat bounce,” a bear-market trap. But it wasn’t.

As the rally gained speed, investors began to think that perhaps the worst of the financial crisis was indeed over and they would buy some stocks on a retracement or when the market tested its lows.

But that didn’t happen either. In fact, the Dow didn’t tire until it crossed 11,000 in May. By then, the market was up over 70% in just 14 months.

That was pretty depressing to investors sitting on the sidelines, earning microscopic yields on their cash. Many were so busy licking their wounds from the sell-off that they made little or no new investments during the rebound.

So what should you do now?

Investing in Stocks: Follow the Earnings

Since the market high four months ago, the Dow has lurched back and forth. But the primary direction has been down. No surprise here. After a rally of this magnitude, a correction is not unusual.

But don’t be like last year’s investors and miss the next rally. Now is a good time to put money to work in high-quality stocks.

In fact, the market is almost as cheap today as it was during the depths of despair in March 2009.

How is that possible when the Dow is more than 3,500 points higher?

Because a stock or index price doesn’t tell you anything about valuation. What matters are earnings and the multiple that the market puts on them.

Three Reasons Why You Should Buy Stocks Today

When measured by profits, the market is almost as cheap today – at 14.9 times trailing earnings and 12.2 times prospective earnings – as it was in March last year.

That’s because earnings are up. Way up. Second quarter profits at U.S. companies hit an all-time record.

A year and a half ago – when investors should have been buying stocks – the media was busy telling them about The Great Recession and how the world was coming apart at the seams.

Today, it provides saturation coverage of home foreclosures, personal bankruptcies and endless political carping. And because we’re blanketed with bad news, few investors see the positives. Consider, for example:

• The Fed has taken interest rates to near zero. That makes it cheaper for consumers and businesses to borrow. It also makes ultra-low-yielding cash a horrible investment.

• Inflation – the great bane of both stock and bond investors – is M.I.A. With the consumer price index showing virtually no increase, businesses don’t have to battle rising costs.

• Around the globe, most stocks are unloved and undervalued. Historically, when the P/E of the S&P 500 has dropped dramatically – as it has since the highs of May – it isn’t long before the market puts on a significant rally.

A Leaner Corporate America Could Drive the Next Rally

I know analysts are saying that earnings won’t be anything great. But they could be wrong – yet again – for two key reasons.

1. Businesses have tightened up their cost structure, laid off unnecessary personnel and refinanced debt at lower levels. Even a modest uptick in sales could deliver surprisingly good bottom-line growth.
2. It’s so cheap for businesses to borrow right now that I expect we’ll see many of them issuing debt to buy back their own shares. This could lead to robust growth in earnings per share, even if growth in gross earnings is less dramatic.

The bottom line?

Investing in Stocks: The Ultimate Contrarian Indicator Right Now

Stocks today are almost as cheap as they were when the Dow hit 6,500 18 months ago. And the macro-economic picture – while always cloudy – is a heck of a lot better now than it was then.

As an investor, look at your options. Cash pays next to nothing. Treasuries yield little more and could easily drop precipitously. Real estate is a non-starter, due to illiquidity, a flood of foreclosures and tough new lending rules.

But stocks offer excellent potential. And if you know anything about contrarian indicators, the fact that so few believe it only confirms it.

Good investing,

Alexander Green

Jeremy Siegel: Treasury Bonds Today Are a Sucker Bet

Jeremy Siegel: Treasury Bonds Today Are a Sucker Bet
by Alexander Green, Chief Investment Strategist
Monday, August 30, 2010: Issue #1334

The investment advisory industry is full of gurus – and various charlatans – claiming that they made incredible stock market calls.

But Wharton Professor Dr. Jeremy Siegel made perhaps the greatest call of all time at the right moment and for the right reasons. Those who listened to him saved themselves many thousands of dollars – and untold agony.

Now Dr. Siegel is making another bold prediction. You can only ignore it at your peril. Here’s why…

Siegel Shocks the Market

On March 13, 2000, The Wall Street Journal ran an op-ed piece from Dr. Siegel entitled “Big-Cap Stocks Are a Sucker Bet.” The column shocked the investment community.

Here was the man, author of the investment classic Stocks for the Long Run and who provided the intellectual underpinnings of the greatest bull market in history, claiming that the greatest stock market darlings weren’t just overvalued. They were a “sucker bet.”

Siegel focused on the 33 largest firms based on market capitalization – those with values greater than $85 billion. Of these, 18 were technology stocks. He noted that their market-weighted P/E equaled 126. What’s more, he pointed out that half of the large-cap technology stocks had P/Es over 100. For these stocks, the market-weighted P/E was 208.

These prices were totally unjustifiable. There was no way that these companies could grow fast enough to support such insane valuations.

Are You Heeding Siegel’s Current Warning?

That month, the Nasdaq – home to these tech giants – hit its all-time high of 5,132. From there, it imploded. Many of the stocks he singled out in the column – like Yahoo! (Nasdaq: YHOO) and JDS Uniphase (Nasdaq: JDSU) – plunged over 99%.

Even today – more than 10 years later – the Nasdaq is 60% below its high.

It’s great when a knowledgeable analyst like this rings a clear warning bell at the top. So understand that he’s doing it again today.

Earlier this month, he wrote another Wall Street Journal op-ed piece. This one is called “The Great American Bond Bubble.”

Siegel says: “What is happening today is the flip side of what happened in 2000. Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.”

As a result, they’re plowing money into Treasuries and Treasury mutual funds.

This will almost certainly end badly.

Unless we have a full-blown deflationary depression, these bonds are a horrible bet, offering minuscule yields and huge downside risk. Many investors don’t realize how badly they can get clobbered in super-safe Treasuries when the bond market turns down. (And those holding leveraged bond funds could see 40% or more of their principal vanish in a matter of months.)

As Siegel concludes: “Those who are now crowding into bonds and bond funds are courting disaster… The possibility of substantial capital losses looms large.”

What does Siegel propose that income investors hold instead?

Don’t Be a Sucker: Invest in This Asset Class Instead

Large-cap dividend stocks.

He points out that the 10 largest dividend payers in the United States are:

AT&T (NYSE: T)

Exxon Mobil (NYSE: XOM)

Chevron (NYSE: CVX)

Procter & Gamble (NYSE: PG)

Johnson & Johnson (NYSE: JNJ)

Verizon (NYSE: VZ)

Phillip Morris (NYSE: PM)

Pfizer (NYSE: PFE)

General Electric (NYSE: GE)

Merck (NYSE: MRK)

And together…

• They sport an average dividend yield of 4%, substantially more than what 10-year Treasuries are paying.
• Their average P/E ratio is 11.7 versus 13 for the S&P 500.
• Aside from the mountain of cash they’re sitting on, their prospective earnings will cover their dividends by more than 2 to 1.

Despite fears of another stock market dip, income investors are wise to switch from Treasuries to high-dividend stocks. It might not feel like the right thing to do, but neither did buying stocks at the market low 17 months ago.

In short, I couldn’t agree with Dr. Siegel more. Treasury bonds today are a sucker bet.

Good investing,

Alexander Green

The Most Politically Incorrect Column Ever

The Most Politically Incorrect Column Ever

by Alexander Green, Chief Investment Strategist
Wednesday, August 18, 2010: Issue #1326

Could reading Investment U cause you to switch party affiliations or change your vote?

Hardly. Political affiliations are generally a combination of values and interests. Few individuals seriously question their notions of right and wrong or have trouble identifying those policies that further their own self-interest.

That’s why political discussions – even the few conducted at relatively low decibel levels – seldom result in anyone changing his or her mind. But according to Dr. Daniel B. Kline, a professor of economics at George Mason University, perhaps some of us should…

How Would You Fare on This Question?

In the May issue of Econ Journal Watch, Dr. Klein cited a recent Zogby International survey, which found that self-identified liberals do very poorly on questions of basic economics.

Zogby asked 4,835 American adults to answer eight survey questions on simple economics and asked respondents to also identify their own political leanings from liberal/progressive to conservative/libertarian.

Consider one of the questions: “Restrictions on housing development make housing less affordable.”

Survey participants were asked if they: 1) strongly agree; 2) somewhat agree; 3) somewhat disagree; 4) strongly disagree: or 5) are not sure.

An answer was only considered wrong if it was flatly unenlightened. (In this instance, “somewhat disagree” or “strongly disagree” were considered wrong. Answering “not sure” was never counted as incorrect.)

An “F” for the Left

Of course, basic economics acknowledges that whatever redeeming features a restriction may have, anything that increases the cost of production or reduces supply will increase the cost to consumers.

Yet 60.1% of respondents who identified themselves as liberals missed this question, as did more than two-thirds (67.6%) who called themselves “very liberal.”

Likewise…

• The majority of liberals disagreed that mandatory licensing of professionals increases the price of services.
• They disagreed that rent controls lead to housing shortages.
• They believe that a company that holds the largest market share in its industry is “a monopoly.”

And so on…

Respondents who identified themselves as very conservative or libertarian missed an average of 1.38 of the eight questions. Those who identified themselves as very liberal or progressive missed an average of 5.26 (a clear “F”.)

The Most Dangerous Economic Myth

Of course, everyone is entitled to their own opinion. But everyone is not entitled to their own facts.

Klein concludes that, “The left has trouble squaring economic thinking with their political psychology, morals and aesthetics.”

I have a strong suspicion that most readers agree. Why?

Because our mail shows that the overwhelming majority of investment readers -perhaps more than 90% – identify themselves somewhere on the conservative/libertarian end of the spectrum.

In some ways this is mystifying. After all, we all have financial needs. We all dream of retiring comfortably some day. But, here again, liberals and conservatives have different views about how this goal should be achieved.

Conservatives have a strong conviction that it is their own responsibility to work, save and invest to ensure some measure of financial independence. Yet surveys regularly show that the majority of liberals feel it is the responsibility of their employer or the federal government to provide for them in retirement.

Of all the economic myths, this one may be the most dangerous. Yet the fact that you’re even reading this column suggests there’s not a 1-in-10 chance you believe it.

Perhaps you should pass it along to someone who does.

Good investing,

Alexander Green

Buying Stocks: Don’t Succumb to The Siren Song of the Naysayers

Buying Stocks: Don’t Succumb to The Siren Song of the Naysayers

by Alexander Green, Chief Investment Strategist
Wednesday, August 11, 2010: Issue #1321

Comedian Dennis Miller used to joke that he was at the airport when his ship came in.

A year from now, plenty of investors are likely to feel the same way. Why?

Because they’re ignoring the good news out there right now and not buying stocks. Instead they’re succumbing to the siren song of the naysayers.

And while no one can know for certain what the stock market will do in the year ahead, there are good reasons to believe that stocks may be substantially higher.

That’s because there are two traditional indicators that investors are wise to heed:

• Don’t fight the Fed
• Don’t fight the tape

Let’s take a closer look at each of these and I’ll show you why…

Don’t Battle with Bernanke

As we all know, the Federal Reserve has taken short-term interest rates to near zero. Moreover, Fed Chairman Bernanke has repeatedly said that he expects to keep them there “for an extended period.”

This is a green light for Fed-watchers. Low interest rates…

• Make it cheaper for corporations to borrow.
• Reduce the cost of owning stocks on margin.
• Make cash and time deposits unattractive relative to stocks.

A stock investor today certainly isn’t fighting the Fed.

Let’s take a closer look at the “don’t fight the tape” part…

Don’t Fight the Tape

The stock market is in a confirmed uptrend. Seventeen months ago, the Dow bottomed near 6,500. It has had its ups and down this year, but the big trend is up, not down.

• If you’re buying stocks, you’re with the tape.
• If you’re short the market or out of stocks, you’re fighting the tape. And that’s not good.

(The tape, of course, is a reference to the ticker tape of yore.)

Some investors tell me they’re not comfortable buying stocks during a recession.

Hello?

It’s true we’re not experiencing robust economic growth. But a recession is defined as two consecutive quarters of negative economic growth. We haven’t had a single negative quarter in the past year. In fact, GDP growth has averaged 2.84% a quarter over the past 12 months.

It doesn’t feel that way, of course, because housing is in a funk, unemployment is high and consumers are reluctant to spend. But for the third consecutive quarter, profits have mostly beaten expectations.

Why? Partly because companies have laid off unnecessary personnel, refinanced debt at lower levels and cut other costs. Even a modest uptick in revenue is causing a big jump in bottom-line profits.

Plus, businesses are benefiting from technological innovation, negligible inflation and booming new markets overseas, particularly in Asia and Latin America.

Feel the Fear… And Buy Stocks Anyway

Other investors tell me they can’t buy stocks because there is just so much gloom and doom out there.

Apparently, they don’t realize that negative sentiment is a powerful contrary indicator. (Or as Warren Buffett often says, you want to be fearful when other investors are greedy and greedy when others are fearful. And without a doubt, investors are fearful right now.)

Of course, there is a lot of negativity because this is an election year, too. Republicans are talking up how bad things are to increase their chances in November. Democrats are conceding that things are bad – and still blaming things on Bush – because they don’t want to seem out of touch.

Indeed, there is plenty to dislike about how the folks in Washington are running the show. But a decision to buy stocks is not an endorsement of any political party or a statement that all is right with the world. It’s merely an acknowledgement that business conditions – and profits – are likely to improve in the future.

If you disagree, that’s fine. But at least concede that you’re fighting the Fed, fighting the tape – and fighting the sentiment indicator.

Historically, that has not been a profitable strategy.

Good investing,

Alexander Green

Is the Media Gaming You?

Is the Media Gaming You?

by Alexander Green, Chief Investment Strategist
Monday, August 9, 2010: Issue #1319

Almost every day, friends and business associates forward me media stories about the economy or the financial markets and ask me to comment.

But my comment on every story – whether bullish or bearish – is always the same: “Perhaps.”

Perhaps the economy will experience a double-dip recession. Perhaps gold will hit $2,000. Perhaps the market will surprise everyone and rally in earnest.

But if this is too indefinite for you, let me emphasize a few certainties…

The Media’s M.O. is Bad for Your Bank Balance

It’s certain that the media doesn’t know who is right or wrong about the stock market, interest rates or currencies.

It’s certain that the “experts” they’re interviewing don’t know either. (Although there is a good living to be made by pretending to know.)

It’s certain that the media doesn’t exist to help you grow your portfolio or achieve financial independence. Rather, the media exists to sell advertising. The best way to maximize advertising revenue is to attract readers (and viewers). And the best way to do that is to have something – anything – sensational to say. Sensationalism grabs people’s attention – and that’s all sponsors really require.

This works beautifully for the media. But does it work for you? Of course not. The media is out to game you.

Hunting for a Good Stock? Ignore the Media and Ask These Nine Questions Instead

Never once have I met an investor who said he made a fortune in the market by constructing a worldview based on media reports and then shuffling his or her money around accordingly.

The very idea is absurd. So rather than listening to some pundit or self-styled guru who has the world all figured out, take a look at the smaller picture. In particular, if you want to make money in the market, seek out a great business and ask:

1. Does the company have good economics? In other words, is it part of an industry that isn’t driven by price competition alone?
2. Does the company have a consumer monopoly or brand name that commands loyalty?
3. Are the earnings on an upward trend with good and consistent profit margins?
4. Is the debt-to-equity ratio low, or the earnings-to-debt ratio high? Can the company repay debt, even in years when earnings are lower than average?
5. Does the company have high and consistent returns on invested capital?
6. Does the company retain earnings for growth?
7. Does the business have high maintenance cost of operations, high capital expenditure or investment cash outflow? (If so, that’s not good.)
8. Does the company reinvest earnings in good business opportunities? Does management have a good track record of profiting from these investments?
9. Is the company free to adjust prices for inflation?

Look for Facts, Not Fluff

As a stock market investor, these are things that are definitely worth knowing. And if you don’t have time to uncover the answers yourself, at least listen to someone who does.

And notice something important. None of the questions above make a good headline. They don’t grab your eye. They don’t force you to pay attention. At least not like “Dow 4,000!” does…

So don’t waste your precious time chewing on economic punditry. Warren Buffett said it best: “Let blockheads read what blockheads wrote.”

Good investing,

Alexander Green

The Only Thing That Guarantees Your Financial Independence

The Only Thing That Guarantees Your Financial Independence

by Alexander Green, Chief Investment Strategist

Monday, August 2, 2010: Issue #1314

Reading Tom Shales in The Washington Post recently, it dawned on me why so many people who should achieve financial independence don’t – and probably never will.

I’m not talking about those who are uneducated, unskilled or just can’t pull their lives together because of drugs, alcohol or crushing personal circumstances. I’m talking about the millions of bright, talented people who have plenty going for them and should be financially secure but aren’t.

If you happen to be one of them, just listen to Tom Shales. He offers a case study in the mindset of personal failure…

The Blame Game

Shales recently reviewed a new primetime TV show by self-help guru Tony Robbins, bestselling author of Awaken the Giant Within and many other books.

I haven’t read Robbins’ books or seen his show and no doubt never will. But I do know his basic mantra: If you want to achieve something in this world, you’d better quit whining and pull yourself up by your bootstraps, especially during tough times like these.

Is this message old, corny, and utterly predictable? Of course. The truth generally is.

But Shales has a bigger beef. He’s irritated that Robbins is “filthy rich” from selling “you know, jillions of books.”

Moreover, he calls Robbins’ message of personal accountability “trash TV” and moans that, “At no point does Robbins suggest that it just might possibly be society that has failed… All the bankruptcies, foreclosures, ruthless credit card companies and crooked captains of commerce – they must just be coincidences.”

Someone pass me the world’s smallest violin…

In a Word: Responsibility

The flip side of Shales’ rant is that those of us who didn’t buy more house than we could afford… didn’t use our home equity as an ATM machine… didn’t get caught up in the mania to flip land and condos because “real estate always goes up”… didn’t max out our credit cards or accept credit we couldn’t manage… we were just lucky, right?

Personally, I find it hard to swallow codswallop like this and keep breakfast down, too.

Sure, there are plenty of good, hard-working people who lost their jobs and fell into tough times through no fault of their own. But the Declaration of Independence proclaims the right to pursue happiness, not a guarantee that “society” will provide it.

Like me, I bet you know plenty of people who lived well beyond their means during the boom times. Now they’re paying for their mistakes. It’s a chastening experience. But most will emerge from this downturn, wiser and hardier souls.

Snivelers like Shales, on the other hand, who blame economic misfortune on corporate corruption (a minuscule portion of all U.S. business activity), greedy lenders (who apparently hog-tied their customers and forced them to take out variable-rate mortgages at gunpoint), or society (”anybody but me,” in other words), are destined to fail and fail again.

Until you take responsibility for your own actions and decisions, you cannot succeed. It’s just one of the laws of life. So what does this mean to you as an investor?

Four Simple Steps to Financial Independence

In short here are four simple steps to achieving financial independence…

• It’s up to you to maximize your income and minimize your outgo.
• It’s up to you to live within your means, use credit wisely (or not at all) and save as much as you reasonably can.
• It’s up to you to outline your financial future and follow a workable plan to achieve long-term financial independence.
• It’s up to you to invest your money wisely, keep a sharp eye on taxes and expenses, or make certain that you delegate this responsibility wisely.

This is how ordinary people begin building wealth in order to achieve financial independence. Of course, it’s much simpler and easier to blame “society” or “the breaks” for your problems.

But carping and complaining isn’t terribly becoming and – as Tony Robbins surely knows – it doesn’t change things anyway.

Good investing,

Alexander Green

Long-Term Treasury Bonds: Consider Yourself Warned…

Long-Term Treasury Bonds: Consider Yourself Warned…

by Alexander Green, Chief Investment Strategist

Monday, July 26, 2010: Issue #1309

The brickbats are starting to pour in.

For months, I’ve warned readers about the bubble developing in long-term Treasury bonds.

Yet what was the top-performing asset class in the first half of 2010?

You guessed it: Long-term Treasury bonds, with a total return – price gains plus interest – of 13.2%.

Why is this happening? Two reasons…

• U.S. stocks performed poorly over the first six months of 2010 – down 5.6%. That’s driving many to the perceived safety of Treasuries.
• The anemic euro is making U.S.-dollar-denominated securities attractive to international investors. And Treasuries are the traditional choice for those fearful of equities.

So does this mean there isn’t a bubble after all? Hardly. In fact, the risk now is greater than ever…

1999: An Internet Odyssey

In the fall of 1999, I belonged to a ritzy tennis club – a time when Internet and technology stocks were all the rage.

My playing partners knew I was in the money management business, so there was plenty of chatter among them about “the New Era” and how “the Internet changes everything.”

Occasionally, one of my buddies would ask which Internet stocks I was buying.

“None,” I said. (I was early to get into the sector and early to get out.) The valuations were outrageous and I didn’t think it would end well.

They were surprised by this view, but kept enthusiastically buying and trading Internet stocks like almost everyone else. And, indeed, those stocks kept right on going up.

As the weeks went by, a familiar ritual developed. I’d walk up to the group and – knowing I didn’t own any – they’d ask how my Internet stocks were doing.

Laughs all around.

This went on week after week, month after month. And judging by the guffaws, the question was funnier each week than the week before.

Until one day it wasn’t funny at all.

2000: Nightmare on Wall Street

In March of 2000, the Nasdaq started coming apart and Internet stocks nosedived. As I approached their courtside table one morning, they abruptly stop talking.

“Morning, guys,” I said. “How are your Internet stocks doing?”

Funny… that line was hilarious before. Now it generated obscene gestures, as well as various suggestions for me and “the horse you rode in on.” Hmm.

What is the lesson here (other than that we shouldn’t laugh at the misfortunes of others)?

It’s that you cannot make a rational judgment about when irrational behavior will end.

The “Twin Demons in the Distance” For Treasury Bonds

Internet stocks went up longer than any logical analysis would predict. So did home prices a few years ago.

And the situation with long Treasury bonds right now also defies analysis. Unless, of course, we’re headed into a massive, deflationary period. But if that’s the case, why are gold and inflation-adjusted Treasuries (TIPS) moving up, too?

Either buyers of gold and TIPS are wrong – or buyers of long-term Treasuries are wrong. I think you know where I stand.

As The Wall Street Journal reported on July 6: “The huge stimulus the Federal Reserve and U.S. government have provided to the economy over the past few years will inevitably push up both interest rates and consumer prices. While the threat isn’t imminent, it’s not too early to take steps to protect the bond part of your portfolio from those twin demons in the distance.”

Consider yourself warned.

Good investing,

Alexander Green

Is Apple the Perfect Growth Stock?

Is Apple the Perfect Growth Stock?

by Alexander Green, Chief Investment Strategist
Monday, July 19, 2010: Issue #1304

I’ve often said that my stock-picking approach can be boiled down to this mantra:

Share prices follow earnings.

I challenge you to look back through history and find even a single company that increased its earnings quarter after quarter, year after year, and the stock didn’t tag along.

By the same token, try to find a company whose earnings were flat or declining year after year and the shares kept rising. It doesn’t happen, even in a roaring bull market.

But is growth in earnings per share all you really need? Could it be that simple?

Of course not.

Any company can increase its earnings for a while merely by cutting expenses. But eventually, a firm reaches a point where it can’t cut costs further without damaging the underlying business. (Obviously, if you reach the point where you’re selling off key infrastructure or laying off top people to boost short-term profits, you’re hurting the company’s long-term prospects.)

There are other important factors as well and I can illustrate a few of them by pointing to a near-perfect growth stock…

Want to See If a Company is Growing? Look to These Three Crucial Factors

In order to see robust bottom-line growth, you need to see substantial top-line growth. In other words, sales have to rise, too.

And Apple, Inc. (Nasdaq: AAPL) is doing just that.

• Sales & Earnings: The company is selling boatloads of iPods, iMacs, iPhones and iPads. In many instances, it’s been unable to keep up with demand. In the most recent quarter, sales jumped 49%. That enabled earnings to soar 90%.
• Profit Margins: This is another important factor. If competitors can come in and easily underprice you, your business is vulnerable.

But Apple is well-protected with its iron-clad patents on the Mac operating system and many of the key features of its bestselling products. So it’s no surprise that operating margins top 29%. Or that Apple is up 63% over the last 52 weeks, even after the recent market dip.

Over time, Apple has brought down the price of most of its products, but not because competitors were forcing them down. Management did it because they wanted to broaden the potential market for Apple’s products. That’s key.

• Return on Equity: This key metric is calculated by dividing earnings per share by book value (or net assets) per share.

Why is this important? Because it tells you how efficiently management is deploying the firm’s capital. Warren Buffett – who puts a great deal of emphasis on ROE – says anything above 17% is good. Apple’s return on equity is twice that.

Happy Customers… Happy Shareholders

Apple has done plenty of other things right, too. It’s a consistent innovator and is a world-class marketer. (Its products are so cool, customers find themselves lusting over things they don’t even need.) And it’s done a good job of keeping a lid on costs.

The end result? Earnings per share have boomed over the last decade. And while the broad market has gone nowhere, shares of Apple are up several-fold.

It’s a classic story of a company that keeps its customers coming back because it makes them happy. And the resulting increase in earnings keeps shareholders delighted, too.

Good investing,

Alexander Green

Why Burton G. Malkiel is More Right Than Wrong

Why Burton G. Malkiel is More Right Than Wrong

by Alexander Green, Chief Investment Strategist
Monday, July 12, 2010: Issue #1299

At FreedomFest in Las Vegas last week, I debated Burton G. Malkiel, author of the investment classic A Random Walk Down Wall Street.

Malkiel is one of just a few men alive who has profoundly affected modern investment thinking. And his position is straightforward.

He believes that rational, self-interested investors take all public information and immediately incorporate it into the price of stocks. (This is where we get the term “efficient market.”)

He therefore concludes that market timing and security analysis is foolhardy… that it’s simply not possible to beat the market over the long term… and that you’d be well advised to give up that dream and just own a broad selection of index funds.

I actually agree with much of what Malkiel says. Much… but certainly not all.

Irrational Exuberance

For starters, you can count on investors to be self-interested. But rational? Not always. Just take a look at recent history…

• How rational were investors 10 years ago when they bid Internet and technology stocks to the skies, forgoing sales and earnings for financial metrics like “eyeballs” and “web hits?”
• How rational were investors five years ago when they put themselves deeply in hock to flip land, rental properties, vacation homes and condos because “real estate always goes up?”
• How rational were investors when they dumped stocks en masse 16 months ago – with the Dow at 6,500 – and plunked the proceeds into money market funds just as yields reached an all-time low?

It’s true that most investors behave rationally most of the time.

But it’s certainly not true that all (or even most) investors behave rationally all the time. And that creates opportunity.

Let’s take a look at another flaw in the “random walk” argument…

Get the Insider Advantage

Malkiel mentions that investors incorporate all “public information” into the price of stocks. But how about non-public information?

Most investors don’t have access to non-public information, that’s true. But that doesn’t mean no one has access to it.

Some of the best trades I’ve ever made have resulted from visiting a retailer and asking the manager how regional and national sales are going. Are they supposed to talk about these things? Absolutely not. But do they?

Sometimes they do. Gaining a bit of key information by talking to customers, suppliers, competitors and employees can give you an edge.

And how about company insiders? Officers and directors have access to all manner of material, non-public information. That gives them an enormous advantage over ordinary investors. And that’s also why Uncle Sam requires them to file a Form 4 with the SEC, divulging the details of their buys and sells.

If you watch what the insiders are doing, you won’t access the non-public information that they possess. But you’ll certainly know whether they think their companies’ shares are overvalued or undervalued. And that’s crucial information.

A 10-Year Market-Beating Performance

In short, Malkiel is right that it’s difficult to beat the market. But does that mean it’s futile to try?

Not only have men like Warren Buffett and Peter Lynch put the lie to that line of thinking, so has our own Oxford Club Trading Portfolio. The independent Hulbert Financial Digest confirms that we’ve beaten the market by a wide margin over the past decade.

But while Malkiel is wrong on some crucial points, he is absolutely right on several others. For example…

• He believes it’s a fool’s errand to try to time the market. I agree.
• He insists that an index fund will outperform the vast majority of actively managed funds over time. He’s right. They have and almost certainly will.
• He argues that index funds provide a big performance boost due to cost-efficiency and tax-efficiency. Right again – and this is far more important over the long haul than most investors realize.

In short, I agree with Malkiel far more than I disagree with him. His research – and similar work by John Bogle, William Bernstein and others – has had a profound impact on the development of my own investment philosophy. In fact, our Gone Fishin’ Portfolio is the very embodiment of much of what he espouses.

And Malkiel may be surprised to learn that this portfolio has beaten the S&P 500 – with far less risk than being fully invested in stocks – every year for over a decade.

I’d call that a non-random success.

Good investing,

Alexander Green

The Japanese Stock Market: How to Play “The Land of Rising Stocks”

The Japanese Stock Market: How to Play “The Land of Rising Stocks”

by Alexander Green, Chief Investment Strategist
Monday, June 28, 2010: Issue #1290

The Wall Street Journal reported last week that, for the first time in three years, foreign investors are increasing their holdings in the Japanese stock market.

Data released by the Tokyo Stock Exchange shows that foreign ownership of Japanese shares rose to 26% for the year that ended in March, up from 23.5% a year earlier.

The Journal suggests that a recovery in Japanese corporate earnings is tempting foreign investors back to the country’s equity markets.

But I think there’s more going on here. Perhaps hedge fund managers and other savvy global investors have paged back through their old, dog-eared copies of Dr. Jeremy Siegel’s Stocks for the Long Run.

If so, they may have recognized something significant…

Crunching the Numbers on Japan

Siegel notes that it’s rare for stocks to go 10 years without giving a positive return. Yet we’ve experienced just such a rarity over the last decade.

For stocks to go 20 years without giving a positive return is almost unheard of. And 30 years? That’s rarer than Big Foot, Nessie and the Abominable Snowman combined.

Which brings me back to Japan…

• In 1989, the Nikkei 225 – Japan’s equivalent of the S&P 500 – hit a new all-time high near 40,000. Today, more than 20 years later, it languishes near 10,000 – almost 75% lower.
• In other words, the Nikkei 225 would have to rise 300% just to get back where it was in 1989.

And it wouldn’t surprise me if it did just that by the end of the decade. After all, it’s happened before.

In the 1970s, the U.S. market returned just 0.34% a year – a 3.4% total return for the decade. Yet the Japanese market compounded at 16%, generating a 10-year return of 344%.

What other asset class offers that kind of potential return over the next decade? (Gold bugs, keep your seats.)

Don’t Chase the Bullet Train… Get on Board Now

The groundwork has been laid.

Last August, after more than 50 years, Japan’s opposition party trounced the Liberal Democratic Party in a landslide election.

The new government has promised to shrink the country’s massive bureaucracy and cut wasteful public spending. It also intends to end more than 20 years of economic stagnation by cutting taxes and focusing on small and mid-sized businesses.

Of course, we’re all skeptical of politicians’ promises, but there is evidence that they mean business this time. Twenty years is a long time to leave your economy in a funk.

It’s resulted in Japanese stocks being among the cheapest and most unloved in the world. Virtually no one is enthusiastic about the Tokyo market.

However, great opportunities are born when dirt-cheap valuations marry investor apathy. Plus, Japanese investors are flush with cash. They’ve largely ignored domestic stocks after two decades of sub-par returns. And as that money begins to find its way out of mattresses and back into Japanese equities, the Tokyo market should lift off.

This is doubly true when institutional money managers return to Japan in a serious way. For years, global fund managers have outperformed the world benchmark by simply underweighting Japan. But let the Shinkansen take off without them and they will be forced to dash after it.

So how do you play this?

Two Ways to Ride the Japanese Stock Market

There are dozens of worthwhile Japanese ADRs trading on Nasdaq and the Big Board.

But you can gain exposure to the Japanese stock market through two ETFs…

• iShares MSCI Japan Index (NYSE: EWJ), which invests in large-cap Japanese stocks.
• Wisdom Tree Japan Small-Cap Dividend Fund (NYSE: DFJ), which captures the best of the Japanese small-cap sector.

Or you can spread your bets and own both.

Incidentally, if you remain skeptical about Japanese stocks digging their way out of this 21-year hole, consider again how unlikely it is that Japanese stocks will earn a negative 30-year return.

As Dr. Siegel writes in Stocks For the Long Run:

“In the 12 years from 1948 to 1960, German stocks rose by over 30% per year in real terms. Indeed, from 1939, when the Germans began the war in Poland, through 1960, the real return on German stocks matched those in the United States and exceeded those in the U.K. Despite the total devastation that the war visited on Germany, the long-run investor made out as well in defeated Germany as in victorious Britain or the United States. The data powerfully attest to the resilience of stocks in the face of seemingly destructive political, social, and economic change.”

The story in Japan was similar. By the end of 1945, stock prices stood at about approximately one-third of their level just prior to the Empire’s surrender. Over the next 40 years, the Japanese market returned more than 20 times its American counterpart.

If 200 years of world stock market history is any guide, the current decade should be another barnburner for Japan.

Good investing,

Alexander Green